1.1.1The fundamental question and the fundamental equation

As mentioned earlier, the original purpose of accounting was to inform business owners about their financial performance. But what does financial performance mean? Financial performance means the value of the business that is available to the owner, which is usually money that can be spent by the owner, but it can also be in other forms of goods or rights.

But our businessman has more than just a bank account with a positive balance. Let us assume he provides consulting services for companies. For that he needs some equipment, so he buys some assets for example a computer, a mobile phone, and some software. He rents office space and buys some office furniture. Thus, he spends money and acquires other assets that have value. Perhaps one of his suppliers does not ask for cash payment but offers credit, which the businessman takes advantage of. Then he acquires some asset; he does not lose money (at least for now) but he does have a liability: He will eventually have to pay a certain amount of money to settle his purchase.

This leads to the following fundamental accounting equation:2

Net Assets = Assets − Liabilities.

The value that is available for the businessman are the net assets, that is all valuable items the business owns minus all obligations for future payments the business incurs. In accounting, net assets are also called (owner’s) equity:

Equity = Assets − Liabilities or Assets = Equity + Liabilities.

This fundamental equation gives the first important information to the owner of the business, and it must be satisfied all the time at a specific point in time; we return to this point later on.

Another important piece of information is change in equity. To analyse a change in equity, we need to look at a specific time period: At the beginning of this period there is a starting value, and at the end there is an ending value. If the ending value is higher than the starting value, equity increased; this is called profit because the value of the business increased. If the ending value is lower than the starting value, then equity decreased; this is called a loss.3

1.1.2Financial and managerial accounting

The original idea of accounting was to inform the owner of a business about the business’s financial situation. In 1494, Luca Pacioli, a Franciscan monk, made the first comprehensive presentation of double-entry bookkeeping. This is the method still used today in the vast majority of companies. In the following sixteenth and seventeenth centuries, it became common practice for businessmen to account for their transactions and to prepare financial statements, usually at the end of the year.4

The wider use and better understanding of accounting and, as a consequence, one’s own financial position allowed people to develop more complex business models: Selling and purchasing on credit, the use of different forms of credit and insurance and, in consequence, the development of a financial sector with banks and insurance companies all occurred in parallel.

With these more complex business transactions, interdependencies grew: If a customer who purchased on credit becomes insolvent and can no longer fulfil his obligations, this may be not only his own problem, because he will remain impoverished and may face penalties for bankruptcy; it may become a problem for his supplier as well because he will lose part of his assets – the receivables of sales made on credit. In consequence – depending on the importance of the insolvent customer – the supplier may incur a loss as well or – even worse – become insolvent himself. Thus, creditworthiness and the ability to judge the creditworthiness of one’s customers became more and more important. To reduce this risk and give creditors access to the necessary information, accounting procedures were made legally mandatory and financial statements had to be published for certain companies. King Louis XIV in 1674 issued the first French accounting law, the “Ordonnance de Commerce”, and in 1861 the first German accounting law, “Allgemeines Deutsches Handelsgesetzbuch”, was issued.5

Other parties wanted to use financial statements: the tax authorities to calculate income taxes, employees to be informed about their employers, and many other parties. All these different users have at least partially different interests in financial statements and focus on different information. The following table gives an examplary overview:

Tab. 1.1: Users of financial statements and their interests6.

Because of the different interests of the various users (stakeholders), different forms of accounting were developed, described in what follows.7

Financial accounting

Financial accounting is based on legal requirements and typically focuses on fulfilling the requirements of users that are outside of the company, which is why this type of accounting is also called external or statutory accounting or reporting. Typically, the financial statements that are the output of financial accounting are prepared once a year (for companies listed on a stock exchange, often quarterly) and then published so that every interested party can acquire the information.

Managerial accounting

Managerial accounting is not a legal requirement but an operational necessity that focuses on fulfilling the information needs of management and, partially, employees. Typically, this information is produced much more often than financial statements, i.e. weekly or monthly (some key data even daily), to support the operational decisions of management. Usually, it not only incorporates actual data (that has occurred) but is supplemented or accompanied by budgeted or planned data. This information is in most cases treated as confidential and not published.

This book focuses on financial accounting and the preparation of financial statements.

1.1.3Content of accounting/basic terms

So far the terms we have used have been more colloquial and not very precise. In what follows, we will distinguish and define important terms that will be used throughout the subsequent chapters.

Cash inflow and cash outflow

In its typical accounting meaning, cash comprises not only cash on hand but also bank accounts with a positive balance that represent short-term assets (often called cash and cash equivalents). A cash inflow is an increase in cash and cash equivalents, for example a customer pays for a delivery by cash or bank transfer. A cash outflow is a decrease in cash and cash equivalents, for example the company pays a supplier by cash or bank transfer.

Proceeds and expenditures

Whereas cash in- or outflows cause a change of the cash available, proceeds or expenditures represent a change in the net financial assets. Net financial assets are defined as cash (and cash equivalents)8 plus receivables minus debt:9

An increase in net financial assets is called proceeds, a decrease is called an expenditure.

Income and expense

A further distinction focuses on changes in net assets, i.e. all assets minus all liabilities:10

An increase in net assets is called income, whereas a decrease is called an expense. This means there can be income or an expense that is not cash flow, proceeds or expenditures.

Income and expense are the basis of financial accounting.

Output/operating income and cost

Whereas income and expense reflect any change in net assets, output and cost focus on the operating processes of the company. Output/operating income is the value of goods produced and services performed in the course of normal operations. Costs are the measured use of goods and services for the normal operating procedures. Output and costs are the basis of cost accounting or managerial accounting.

Some costs are identical to expenses: These are called basic costs or operating expenses. Expenses that are not costs are called neutral expenses. Costs that are not expenses are called imputed costs. Figure 1.1 shows the differences in more detail.11

The same logic can be applied to income and output.

Neutral expenses can be further classified as follows:

Imputed costs can be distinguished as follows:

1.2.1Balance sheet

After clarifying the basic accounting terms, let us return to the basic accounting equation:

Assets = Equity + Liabilities

As mentioned earlier, this equation must be fulfilled all the time at a specific point in time, i.e. it is balanced (a change in assets is reflected by a change in equity or liabilities). Furthermore, assets and liabilities are split into different categories, and the split is presented in two columns. This is called a balance sheet.13

The equity and liability side shows the future financial obligations (i.e. liabilities) and what is left for the owners of the business (i.e. equity). Usually, a company has future financial obligations if it has received financial funds or resources, for example if the company takes on a loan, it receives money today with the obligation to repay the loan (and additional interest) in the future. Thus, the equity and liability side shows the source of financial funds and resources.

On the other hand, the asset side shows what the financial funds were used for, i.e. what assets were acquired. If some of the raised financial funds were not used, they are reported on the asset side as cash and cash equivalents.

This is the basic structure; the more detailed legal requirements are explained later (Chapter 3.1.1), as is the content of deferred items (Chapter 3.1.10.1).

1.2.2Income statement and changes-in-equity statement

As explained earlier, an increase in equity is called profit, whereas a decrease in equity is called a loss if it is not due to external changes such as additionally paid-in money or withdrawal of money. Being able to analyse the sources of profits or losses is very important for management. This is not possible with the balance sheet because there changes in equity are simply reported, i.e. you can see that you made a profit, but not why.

To make this analysis possible, all income and expense items are reported separately in the income statement (recall that we defined income as an increase in equity and expense as a decrease in equity). Line by line, different categories of income and expense are summed up to obtain the profit or loss in the reporting period, which then changes the equity.14 Thus, the income statement is a subcategory (later we will call it a subaccount or subledger) of equity that is reported separately for clarity.15

The balance sheet and income statement are the mandatory parts of financial statements. Depending on the company’s size, structure, legal forms or financing forms, other elements may be required.

The changes-in-equity statement explains all changes in equity, which includes the profit or loss in the period as well as any external changes or reclassifications within equity. The changes-in-equity statement is not mandatory for all companies according to German GAAP16.

1.2.3Cash flow statement

Like the income statement, which explains internal changes in equity, the cash flow statement explains changes in cash and cash equivalents. Whereas the income statement is based on income and expenses, the cash flow statement is based on cash inflows and outflows. It makes it possible to analyse where cash is generated or used by calculating cash flow from operating activities, investing activities and financing activities.17

A cash flow statement is not mandatory for all companies under German GAAP.

1.2.4Notes and management report

To be able to understand, interpret and analyse the balance sheet and income statement beyond the raw figures, additional information about the content of the financial statements and the way they are prepared is necessary. This information is given in the notes. Notes are not mandatory for all companies under German GAAP.18

Apart from the quantitative information in the balance sheet and income statement, a verbal description of the course of business during the reporting period and the situation at the closing date, as well as a forecast for the near future, might be helpful in terms of evaluating the situation of a company. This information is given in a management report. A management report is not mandatory for all companies under German GAAP.19

1.3.1Accounts, debiting, crediting

The financial statements as described earlier consist of summarized, aggregated information. Even small companies usually have several hundreds or thousands of transactions that need to be recorded. A direct entry in a balance sheet or income statement would be very confusing and time consuming. Therefore, accounts are used. An account is a summary of similar transactions. It has – as the balance sheet – two columns; the left column is the debit side, the right column is the credit side. This naming applies to the balance sheet as well.20

In the balance sheet in Figure 1.2 the assets are recorded in the left column, i.e. on the debit side. Thus, an increase (or a first recognition) of an asset is always recorded as a debit entry in the left column of an account. A decrease or disposal of an asset is then recorded on the right side, i.e. as a credit entry.

An entry on the debit side of an account is called debiting, and an entry on the credit side is called crediting.

As shown in Figure 1.2, equity and liabilities are recorded in the right column, the credit side. Therefore, an increase in equity or liabilities is a credit entry, whereas a decrease is a debit entry.

If the sum of all debit entries is larger than all credit entries at a specific point in time, this account is said to have a debit balance; if the opposite is true, it is called a credit balance (Figure 1.3). Therefore, asset accounts (e.g. “machinery” or “raw materials”) typically have a debit balance at year end, whereas equity and liability accounts (e.g. “bank loans” or “trade payables”) typically have a credit balance.

Recall the definition of income as an increase in equity. As increases in equity are recorded as a credit entry, any income is recorded as a credit entry on an account. In consequence, an expense is recorded as a debit entry because it reduces equity. Therefore, income accounts typically have a credit balance at year end and expense accounts have typically a debit balance (Table 1.2).21

Tab. 1.2: Accounting rules.

1.3.2Journalizing and posting

The basic accounting equation

Assets = Equity + Liabilities

must be satisfied at all times.22 That is why any transaction that is recorded in an accounting system has at least one debit entry and one credit entry, and the sum of all debit entries must equal the sum of all credit entries. This procedure is called journalizing and is the reason why this form of accounting is called double-entry bookkeeping: A journal entry always has (at least) one debit and (at least) one credit entry, and they must balance.

All transactions are first recorded in chronological order; the documentation of all transactions is called a journal. If all journal entries are correct (i.e. balanced), then the system of double-entry bookkeeping is retained. The journal itself helps to detect errors because it allows for searches by transaction or date.23

Example24

Transaction 1

A company purchases new raw materials for €10,000 on credit; the delivery and the invoice are received on 15 May 15 20X1.

Journal entry

Debit raw materials	10,000	Increase in asset account
Credit trade payables	10,000	Increase in liability account

Transaction 2

The same day, the company sells products for €15,000 in cash.25

Journal entry

Debit cash	15,000	Increase in asset account
Credit sales revenue	15,000	Increase in income account

Transaction 3

The same day, the company receives an invoice from its tax consultant in the amount of €2,500.

Journal entry

Debit consulting expenses	2,500	Increase in expense account
Credit trade payables	2,500	Increase in liability account

The journal entries for this day (assuming no other transactions) look as follows (Table 1.3):

Tab. 1.3: Example of a journal.

For analysing the financial situation of a company, the journal is not really helpful because many different kinds of transactions are mixed in, just as they occurred. To allow for an analysis, organization by kind of transaction is needed, i.e. identical or similar transactions are grouped together. This is done by transferring the individual entries of the journal to accounts. This is called posting. All accounts of the balance sheet and income statement together are called the general ledger.26

A modern information-technology-based accounting system does the posting automatically together with the journal entry; journal and accounts/ledgers represent just two different perspectives on the same transactions. In earlier times, companies kept two large books, which had to be kept manually. First, all transactions were entered in the journal to make sure that all transactions were recorded. Then, in a second step, the journal entries had to be copied to the second book, the general ledger. This basic logic still works today, even if it is no longer technically necessary.

1.3.3Opening and closing of accounts

We have already looked at two accounting procedures, journalizing and posting, but to complete an accounting cycle others are necessary:

Not all accounts are closed directly to the closing balance sheet; there is a hierarchy of accounts (Table 1.9):

Tab. 1.9: Closing accounts.

Thus, the closing balance sheet is the final summary of all transactions that had to be recorded during the reporting period, even if the reporting was done by a hierarchy of accounts and, thus, multiple closing entries.

A trial balance is a preparatory balance that is produced during the reporting period, typically for control purposes.

The total procedures in overview are as follows:

1.3.4Specific topics of double-entry accounting